Definitions:
According to prof. Meyers, Interest is the price paid for the use of loanable
funds.
Prof. Keynes defined interest as a purely monetary phenomenon. According
to him, It is the reward for parting with the liquidity of the money.
Modern economist view interest as the reward for the productivity or pure
yield of capital of savings, for the forgoing of liquidity and the supply of
money. It, therefore, relates to the demand for and supply of money.
GROSS INTEREST AND NET INTEREST
The whole income received by the lender of capital from the borrower is a
Gross Interest. Net Interest is only a part of this gross interest. Besides net
interest, gross interest also includes several other payments and charges for
inconveniences and risks involved in lending operations.
Gross Interest comprises of four elements:
Net or Pure Interest: It is only the payment for the loan of capital. This
payment is made by the borrower for productivity of capital only.
Insurance against Risk: A part of interest received by the lender is a
payment for the risk undergone by lending money to the borrower.
Smaller the risk involved in a loan, the lower shall be the interest rate.
Payment for inconvenience: A lender has to face a good deal of
inconvenience when lending money to the borrower. His money is locked
up for the period of credit. He, therefore, compensates himself for this
inconvenience by adding one or two percent to the net interest.
Reward for management: Every lender has to incur some expenditure
on the management of the loan. For example, he has to keep a separate
account for every borrower and many have to knock at the borrowers
door several times for the collection of debts. All this results in extra
expenditure and the lender compensate himself against this by adding one
or two percent to the net interest chargeable on the loan.
variations of possible projects and to select only those that provide a total
risk-return trade-off consistent with its goals.